Intelligent Semiconductor is considering issuing additional common stock. The current yield to maturity on the firm's outstanding senior long-term debt is 13%. The company's combined federal/state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be
13.5%. Shares of Intelligent Semiconductor have a historical beta of 1.6. In the past, the firm has assumed a 265 basis point risk premium when calculating the cost of equity. What is the cost of equity for this proposed common stock issue using the Bond-Yield-plus-Risk-Premium approach?
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A. B. C. D. E.A
The cost of issuing common stock can be calculated using several methods, including the Bond-Yield- Plus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. In this example, you have been asked to calculate the cost of equity using the Bond-Yield-plus- Risk-
Premium approach. This method is a rather ad hoc procedure used by finance professionals, and involves adding a subjective "risk premium" to the yield to maturity of the firm's outstanding debt. This approach should be used with a degree of caution, as the subjective nature of the procedure leaves significant room for variation in estimates. In using the Bond-Yield-Plus-Risk-Premium approach, a subjective risk premium is added to the yield to maturity of the firm's outstanding long-term debt, and the calculation of the correct answer in this case is as follows: {yield to maturity of the outstanding senior debt 13% + subjective risk premium 2.65%}=15.65%.